Saturday, July 3, 2010

There has been a lot of discussion over financial regulation lately. My view has always been that trying to regulate financial entities is like herding cats. Just when you think you’ve got them rounded up, one or two get away and trouble starts all over again.
Consider this exchange with a hedge fund manager about how clueless people participated in bubble creation [emphasis added]:

HFM: Look, bubbles create other bubbles, they’re like derivative bubbles, so to the extent that there was a bubble in credit or a bubble in the mortgage market, that created a bubble for people who could trade those products. There was a misallocation of resources not only into mortgages, let’s say, but also into the trading of mortgages, and it sucked talent into those areas that probably should be deployed other places. And the way talent gets sucked into those places is by a price signal, the compensation going out. So what was happening was that the pay scale for finance was just—incredibly out of whack. You had guys who were literally just a couple of years out of college, maybe they’d done a year or two at an investment bank, making several hundred thousand dollars a year doing pretty low-value-added Excel-modeling tasks…

It was kind of crazy what people were being paid. And for the more senior people, the kind of deals they were getting—because their pay tends to be not just a number range but a percentage of the profits they generate—they were getting very high percentages of the profits, and very high guaranteed income. The decision to pay those kinds of numbers was motivated by the fact that other places were paying those kinds of numbers, and their ability to pay those kinds of numbers was motivated by the fact that there were huge amounts of assets coming into hedge funds, and hedge funds are able to charge a management fee for the assets under management. So if you had tons of assets coming in, you needed people to manage those assets, you had to get quality people, you had a ton of money to spend, and everybody was looking for people who had a resume that singled them out, or that identified them as qualified to work at a hedge fund—there was just tremendous competition for those people, and it drove prices to ridiculous levels. It changed people’s attitudes—there was a palpable cockiness that one sensed from employees. And there was a lack of distinction I think between people who were really good, who you would want in any environment, and people who you could just fill a seat with because they had a resume that stamped them as minimally qualified.

There are a lot of very creative people working on Wall Street and they will engage in regulatory arbitrage. If you try to regulate one activity, e.g. how hot IPOs are distributed, that particular problem will go away but that creative talent will go elsewhere to do something else that creates the next regulatory problem.

It’s not that I am ideologically opposed to regulation, but in this case a heavy-handed regulatory approach just doesn’t work. The correct solution is to create the right operating structure for the financial marketplace:

Complete and timely disclosure; and

Symmetric incentives.

The disclosure part is easy to understand. Complete and timely disclosure doesn’t allow one side to stack the deck.

The second part is a little bit more subtle. The current structure at investment banks aren’t incentivizing people to get rich slowly by building long-term relationships, but to get rich quickly by doing the trade while ignoring the long-tailed risks that may come with the trade. That’s an asymmetric incentive structure. One very simple solution is to bring back the partnership investment bank. Barry Ritholz and I are on the same page on this issue and he correctly points out that none of the Wall Street partnerships got into trouble in the last financial crisis.

In praise of good government
While I am disinclined to regulate, it doesn’t mean that government is inherently bad. In fact, good government can be a positive force in creating the structure for economic growth.

For the Tea Partiers and Libertarians out there, consider this. Consider this modern account (from the same aforementioned hedge fund manager) of what happens when you don’t have good government:

[T]here’s something very attractive from an investment standpoint of going to a place like Lagos... You’d go to an office building or a hotel and in the course of the day the power goes out six times and the generator kicks on to power the building, and that generator is powered by diesel, and you see all these fuel trucks all over the place that have to bring diesel to fuel the generator, and the generators are noisy and loud. You’re like, “Wow, there’s an obvious opportunity here. Somebody should build a reliable power plant! It would just be tremendous, a tremendous economic efficiency, because you wouldn’t need all these diesel trucks zooming around, you wouldn’t need all these generators…”

Then you realize that the place sounds like a scene from The Sopranos:

But then you realize that it’s not like they can’t figure this out. It’s not like they don’t get the fact that it’s pretty annoying that the power goes out six times a day and it’s pretty annoying to have six fuel generators humming all the time. The reason investment doesn’t happen is because it’s in some powerful person’s interest that it not happen. There’s some guy who controls the diesel trucks who makes tons of money from being a diesel distributor, and there’s a guy with all these generators who would be out of business if power plants were built, and he stands in the way.

In fact, the structure of the fictional Soprano mobster family sounds an awful lot like the feudal states of a bygone era, where the baron (don) lorded over his estate surrounded by his knights (his "crew" of “made men”). But wait, are feudal states really from a bygone era? Wasn’t Ferdinand Marcos just a king by another name? What about Dear Leader Kim of North Korea? Consider this account from Foreign Policy about what is clouding our perception of Afghanistan:

Western observers attempting to come to grips with Afghanistan's fragmented state authority also find themselves drawn to other aspects of the medieval era, a period in which leadership in Europe was personal rather than bureaucratic and the state's power to impose its will quite limited.

The difficulty for a monarch was that the resources remained in the hands of his vassals, who then acted in their own interests. The rise of centralized states in Europe in the 16th through 18th centuries finished a process by which monarchs gradually centralized power and dispossessed their feudal nobilities. Then, in the beginning of the 19th century, the rise of the European nation-state took this process a step further and dispossessed the monarchs while keeping intact the centralized administrations they had built.

Foreigners encountering Afghanistan in the post-2001 era saw this devolution of power as an example of state failure. Many of the multiple competitors for legitimate authority at the local level had no desire to participate in politics in a state-centered system. Autonomous tribes and ethnic groups, local militia commanders, criminal syndicates, and even blood-feuding families sought to resist state power, but they did not seek to overturn or replace it. This arrangement is analogous to medieval Europe, where kings were frequently also unable to maintain a monopoly on the legitimate use of violence, but were still able to retain their thrones.

Is that what we really want? Be careful about what you wish for when you want the government off your back.

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Welcome to my blog Humble Student of the Markets. These are my observations and musings about the markets (mostly equities), hedge funds and investments in general.My experience has been a quantitative equity manager in US, Canada, EAFE and Emerging Markets and commentator on hedge funds and their returns patterns.

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